The Swiss market for structured financial products ranks among the largest in the world and is still growing rapidly. Structured products consist of two or more different components, one of which must be a derivative (see Stoimenov and Wilkens (2005)). They are issued by banks and may be addressed to private or institutional investors. The products can be traded on an organized exchange or sold directly by their issuing bank, who will quote bid and ask prices. A unique characteristic of the Swiss market is that structured products with “exotic” options are extremely prominent. In particular, barrier reverse convertibles represent more than one third of the market (in terms of the total number of products). The majority of these contain multi-asset options, and are called multiple barrier reverse convertibles (MBRC). In other countries, an active market only exists for simpler types of reverse convertibles. Thus, the Swiss market offers an exceptional opportunity to study the evolution of financial design, investor behavior and the pricing of complex financial instruments.

The buyer of an MBRC is entitled to receive a fixed coupon payment on its face value, just like the buyer of a straight bond. In contrast to a bondholder, however, he may receive assets instead of cash repayment of the face value at maturity. The issuer of the MBRC has the right to deliver the underlying asset with the worst performance, provided that at least one of the assets has crossed a downside barrier during the lifetime of the contract. In Switzerland, most MBRCs have an initial time to maturity of one year and are based on three underlying stocks.

Although market pricing of some classes of structured products is well documented in the literature, MBRCs appear to be particularly interesting for at least three reasons. First, in one of the major markets, the product is more prominent and practically relevant than any other structured product with ‘exotic’ elements. Second, due to the complexity of the instrument, its valuation is not straightforward. Since no suitable pricing tools are publicly available, transparency with respect to fair values and value determinants is supposed to be poor. For this reason, it is questionable whether the competition between issuers is strong enough to ensure fair pricing. Third, MBRC are constructed such that two attractive features stand out, namely the high coupon payment (of typically about 10%) and the conditional capital protection (in case none of the barriers is broken). If investors with bounded rationality pay too much attention to these features, they might show an exaggerated willingness-to-pay. As a result, overpricing might be particularly pronounced. Its magnitude is important for investors as well as regulators of financial markets.

To the best of our knowledge, this is the first empirical study of MBRC pricing. Our study is based on a unique and comprehensive database of 468 MBRC in the primary Swiss market. We propose a fast and accurate numerical valuation method based on the tree model of Chen et al. (2002) which is a significant improvement over the commonly used Monte Carlo simulation. A further main contribution is to go beyond a descriptive analysis of price differences by examining the role of market frictions and behavioral biases as determinants of overpricing.

We obtain an average overpricing in the range of 3.4% to 6% for 468 certificates outstanding in April 2007. If this premium is attributed only to the short put option embedded in the product, it corresponds to an average price discount of at least 29%. The product overpricing turns out to be positively related to the coupon level, suggesting that investors tend to overweight the value of the sure coupon and downplay the risk involved. This behavioral bias appears to be important in explaining the success of the product.

The remainder of the paper is structured as follows: in Section 2, we review the literature on pricing reverse convertibles. In Section 3, we characterize the MBRC and present our valuation model. Sections 4 to 6 contain the hypotheses, a description of the database, and our empirical results. We conclude with a brief summary of our findings.

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